Behind the rosier economic numbers

This has been a good week for economic news in the U.S. The latest manufacturing numbers show accelerating production and demand in May, marking the fourth-straight month of improvements. Auto sales were up in double-digit fashion last month, and construction spending hit a five-year high in April. These reports add to the gathering evidence that the national economy is getting healthier.

How this good news impacts the stock and bond markets is a different issue. There’s a tendency to assume that a strengthening economy is a positive for stocks and a negative for bonds, but the relationship is not that direct or that simple. As we saw between 2009 and 2013, the stock market can roar forward even when the economy is shifting between neutral and reverse.

The big question for stock investors now is not, “Is the economy growing?” What they should be asking is, “Is the economy growing fast enough and reliably enough to produce the revenue and earnings gains needed to justify current stock valuations?”

On the fixed income side, the taper of the Federal Reserve’s quantitative easing policy was bemoaned as the coming kiss of death for bonds. The Fed has cut its QE stimulus nearly in half since January, a course of action that was widely expected to send interest rates higher and bond prices lower. It hasn’t happened, at least not yet — bond prices are just off their highs for the year as demand remains high.

We have long believed that, while interest rates would rise over the longer term, this rise would be much more gradual than the market was expecting. This notion of “lower for longer” leads back to what we’re seeing in the economy.

First, the Great Recession of 2007-09 certainly earned its capital letters for being the worst economic downturn in the U.S. in eight decades. Making it worse was the fact that it was a global “balance-sheet recession” created when individuals, companies and governments found themselves overwhelmed by debt. Recovery from a balance-sheet recession tends to be slow and fragile, as we’ve been seeing in this case. The last three took, on average, more than 15 years to work through, and interest rates tended to stay low for most of that span.

Then there’s the on-again, off-again economic growth pattern seen since late 2013. The consensus is that bad winter weather was to blame, but we’re not entirely convinced. Parts of the U.S. where the weather was fine also lagged, while Canada, where the weather was at least as bad, fared better.

Many of those who support the weather theory point to the second quarter’s improving numbers and predict a growth upswing in the second half of 2014. It would be great if it happened. We think growth will be OK in the second half, though it will likely fall short of the 3 percent-plus growth expectations at the beginning of the year. The market is working very hard to justify higher valuations, but at the end of the day, what we’re seeing from investors is modest momentum driven more by complacency than anything else.

The Fed’s three rounds of QE since 2010 were conceived as a way to try to accelerate the recovery process. But each time the Fed sees blue skies and starts pulling back on QE, deflationary forces re-emerge and push down bond yields. Exactly why this is occurring is not clear, though we suspect it may indicate that the economy has not yet progressed to the point where it can support sustainable growth without the Fed’s helping hand. Fed Chair Janet Yellen has hinted that she may be thinking similar thoughts.

Of course, the U.S. is not alone in this predicament. In Europe, some sort of stimulus is expected this week by the European Central Bank to try to goose a little more growth and to back a little farther away from its deflationary chasm.

The choice there to date has been a tough one: either imposing a longer period of austerity on the eurozone periphery (a course of action that so far has devastated the prospects of an entire generation of young people) or imposing more inflation on Germany, which would run counter to that nation’s economic DNA. The ECB is seeking a third path, one that might buy the eurozone some time to try to grow its way out of its problems. The question is whether any action by the ECB will be enough to have a chance at achieving the desired result.

USAA Investments Managed Portfolio Outlook

Our view of caution toward U.S. equities remains unchanged — we are underweight U.S. large caps and small caps. While signs point to continued recovery of the U.S. economy, valuations are no longer cheap, and profit margins are near record highs. The USAA Income Stock Fund seeks dividends and dividend growth as contributors to total return.

We are tactically underweight fixed income, primarily to fund a deployable cash position. Within fixed income, we prefer areas of the market that are more credit-sensitive and less sensitive to changes in interest rates, such as investment-grade corporate bonds and high-yield bonds. The USAA Intermediate-Term Bond Fund and the USAA High Income Fund fit this profile.

We are overweight to assets that are positively correlated to inflation expectations. The USAA Real Return Fund provides potential protection against the risks of long-term inflation.

We are overweight non-U.S. developed markets and emerging markets based on relative valuations. Though they have been hit especially hard recently, we believe that emerging markets remain attractive. Along with compelling valuations, they offer an interesting long-term prospect for growth. The USAA Emerging Markets Fund offers exposure to stocks in less-developed countries.

As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are best suited for your individual goals, objectives, risk tolerance and time horizon.

This material is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing.

Consider the investment objectives, risks, charges and expenses of the USAA mutual funds carefully before investing. Contact us at 1-800-531-8910 for a prospectus containing this and other information about the funds from USAA Investment Management Company, Distributor. Read it carefully before investing.

As interest rates rise, existing bond prices fall. Non-investment grade securities are considered speculative and are subject to significant credit risk. They are sometimes referred to as junk bonds since they represent a greater risk of default than more creditworthy investment-grade securities.

Some income may be subject to state or local taxes or the federal alternative minimum tax.

Foreign investing is subject to additional risks, such as currency fluctuations, market illiquidity, and political instability. Emerging market countries are most volatile. Emerging market countries are less diverse and mature than other countries and tend to be politically less stable.

The S&P 500 Index is a well-known stock market index that includes common stocks of 500 companies from several industrial sectors representing a significant portion of the market value of all stocks publicly traded in the United States. Most of these stocks are listed on the New York Stock Exchange.

Standard & Poor’s 500 Index and S&P are registered trademarks. The S&P 500 Index is an unmanaged index of 500 stocks. The S&P 500 focuses on the large cap segment of the market, covering 75% of the U.S. equities market. S&P 500 is a trademark of the McGraw-Hill Companies, Inc.

The Russell 2000® Index is an unmanaged index which consists of the 2,000 smallest companies in the Russell 3,000 Index, and is a widely recognized small cap index.

USAA or its affiliates do not provide tax advice. Taxpayers should seek advice based upon their own particular circumstances from an independent tax advisor.

High double digit returns are attributable, in part, to unusually favorable market conditions and may not be repeated or consistently achieved in the future.

The Real Return Fund may be subject to stock market risk and is non-diversified which means that it may invest a greater percentage of its assets in a single issuer. Individual stocks will fluctuate in response to the activities of individual companies, general market, and economic conditions domestically and abroad. When redeemed or sold, may be worth more or less than the original cost.

Managed Accounts is a service of USAA Investment Management Company (USAA), a registered investment adviser and broker dealer.

Community Managers

Briana Hartzell

Briana knows all about moving. This Navy wife has helped her husband relocate to four different naval air stations in the last three years. A former USAA employee, Briana is co-founder of The Triple Dish, a blog focused on food, fitness and military life.

Wendy Poling

Wendy is a social media strategist and founder of MyMilitaryLife.com, featuring a popular military spouse blog and the hit podcast Navy Wife Radio and now Military Life Radio. She is the wife of a submariner who has also served in Afghanistan.

Charles "Chazz" Pratt

Charles "Chazz" Pratt III is a former U.S. Army Captain who made the Military-to-Civilian career transition in 1994. In his book, The Fort Living Room Transition Course, he shares valuable tips & tricks to help you succeed. Since his transition from the military, he's worked for several Fortune 500 companies, including Pfizer, Genentech, and St. Jude Medical, among others.